Brazil is a key test for world economy 11-14-98

} Brazil is test for the world economy A lot rides on whether it will follow Korea or Russia By Rex Nutting, CBS MarketWatch Last Update: See news story on Brazil

WASHINGTON (CBS.MW) -- The medium-term fate of the U.S. and world economies may hinge on a simple question: Is Brazil more like Korea or Russia?

If Brazil is like Korea and is able to stop the outflow of capital, then the global crisis may have run its course and U.S. investors can breathe easier. But if Brazil is another Russia and devalues its currency against orders, then the global panic has just begun.

"I don't think there's
any serious or significant comparability between this and the Russian situation."
Robert Rubin

Now that the International Monetary Fund has approved a $41.5 billion, three-year loan package for Brazil, the big question remaining is: Will the program work to stem the daily flight of $200 million in capital from Latin America's largest economy, or will the IMF's program fall apart under the weight of political opposition and internal contradictions?

Divided opinion

As you'd expect, the mainstream of economic punditry in Washington firmly backs the IMF and its demands that Brazil slash its government spending, hike interest rates and protect the real. "The stakes are high," said C. Fred Bergsten, president of the Institute for International Economics.

"Brazil has to do it," said Andrew Szamosszegi, an economist at the Economic Strategy Institute.

Bergsten and Szamosszegi agree with Treasury Secretary Robert Rubin and others in Washington that the line must be drawn at Brazil. If Brazil falls, they say, Latin America could go, and that would create real economic problems in the United States.

The stakes are high. "If Brazil gets into trouble, that could spill over into Argentina," Bergsten said. "That would raise questions about currency boards, and that would spill over to Hong Kong, and that would spill back to China." If China devalues, another round of turmoil would be set off in Asia, Bergsten said.

Critics of the IMF, on the other hand, say the IMF is increasingly out of touch with reality. "Things look very different inside Brazil," said Doug Hellinger, executive director of the Development GAP, a long-time leader in the opposition to the IMF. "They are skewing internal policies to satisfy international investors and banks."

Bad year

It hasn't been a good year for the IMF. Its multibillion-dollar programs in South Korea and Thailand seem to be working, at least if you judge from foreign exchange levels, interest rates and stock-market valuations. The bleeding has stopped.

But elsewhere, notably in Russia, Indonesia and Malaysia, the IMF's programs have failed, to one degree or another. The complete rejection of the IMF program by Russia has reverberated around the world, causing banks and hedge funds to lose billions as their interconnected trades fell apart.

A similar failure in Brazil would have far greater consequences. Americans have a long and deep economic relationship with Brazil. U.S. banks have much more exposure to Brazil and the other South American nations than they had either in Russia or in eastern Asia.

At a White House briefing Friday, Rubin and Deputy Treasury Secretary Lawrence Summers said over and over that Brazil is nothing like Russia. "I don't think there's any serious or significant comparability between this and the Russian situation," Rubin said, pointing to the commitment of President Fernando Henrique Cardoso and the national assembly, which proved its resolve by approving a tough pension reform bill.

Austerity plan

The key to the IMF plan is for the Brazilian government to cut spending by about $23 billion. "It'll work if they stick to the budget plan," Szamosszegi said. "The question is whether they can stick to it as advertised.

"Austerity is absolutely essential," said Szamosszegi. "They have a budget deficit of 8 or 8.5 percent."

Bergsten said the IMF's $42 billion will be sufficient to stem capital flight, if the program is implemented correctly. The key is to reassure creditors that the real won't be devalued. Brazil has about $40 billion in currency reserves and about $80 billion in foreign debt, so the $42 billion package "could fill the gap, theoretically," Szamosszegi said.

Cutting spending won't be that easy, despite guarantees of an adequate safety net. Just as in Russia, government spending in Brazil has powerful constituencies that aren't necessarily recognized in Washington.

Hellinger, who just returned from Brazil, said Cardoso and the IMF do not have the support of powerful political institutions like the assembly or the state governors. "This is a country that has the most unequal income distribution in the world," Hellinger said. Cutting spending, he said, means "squeezing individuals, squeezing demand."

He noted that "Brazil is a very good test of the political viability of some of these reforms."

What's permissible

Hellinger said the past year has created an opportunity for alternatives to the IMF to flourish. "Russia could be the most important case," he said, because "Russia sets out the parameters of what's permissible." Brazil, like Russia, is large enough to go its own way economically, he said.

"Somebody's got to reflate these economies," Hellinger said. "They've got to rebuild their productive capacity." His prescription includes governments imposing some control over capital flows and trade to give precedence to the domestic economy ahead of the interests of foreign capital. That would require raising more capital at home, lowering interest rates and adopting pro-employment policies.

In the long run, such policies not only would make the local economy stronger but would create better trade partners for the United States, Hellinger said.

In the short run, however, the failure of the Brazil plan and an ensuing Latin American recession could cripple both U.S. markets and the U.S. economy -- not to mention the terrible price it would exact from the rest of the continent.

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